There is room for growth in the Lebanese startup market, but in which direction will it grow?

The startup has to be the oldest form of business by virtue of the inane but compelling realization that one can’t have a business without starting one. And in the knowledge that every beginning is in some ways chaotic, Executive has observed and documented in the past three years how creative disorder and an environment of adversity have been conducive to the formation of a startup economy in Lebanon.

Within a few years, the country morphed from a regional startup backyard to a showroom of tech entrepreneurship, with numbers to boast about. From accounting for less than 10 percent of venture capital deals in the Middle East and North Africa between 2006 and 2011, Lebanon leapt to a 27 percent share of Venture Capital (VC) transactions in 2014 according to reports by the MENA Private Equity Association. People who experienced this evolution from the inside as managers of incubators, accelerators and venture capital funds agree that the explosive growth of the startup economy defied every prediction.

But whereas the conception of the startup economy may have been impossible to plan, it was not just a matter of coincidence. The creation of the Beirut Digital District (BDD) as a real estate base for the community and the financial institution of Circular 331 were two fortuitous events in the process that Executive has witnessed unfolding since the start of 2013. Now has come the time to look further into the future and ask when and how to put a real system into the startup economy.

A real system in the sense of entrepreneurship is paradoxical in that it must not be one that boxes innovative companies into narrow, prefabricated frames, but rather has to enable entrepreneurs to employ the best and strongest business frameworks and put them to new uses. In this sense, it can be predicted today that the financing, mentoring, skill building and market access conditions of Lebanon will have to transform and advance in a further leap within two to three or at most about five years. Otherwise the factors that facilitated Lebanon’s emergence as a startup hub in the past three to four years will run a high risk of turning into barriers for further growth.

Taking finance further, but how?

One key area where needs will grow is finance. Paving new financing avenues for later-stage funding is a necessity even under the assumption that commercial banks will continue to deliver a sufficient money flow via venture funds and private equity firms or, ideally, through their yet-to-be-developed own capabilities and appetites, to feed the seed and early-stage needs after the seven-year time frame of Circular 331.

The intuitive answer to the funding gap would be democratization of investment structures, meaning the crowd. By the indications of its exponential growth in the past half decade, crowdfunding appeals naturally to denizens of the digital sphere on both social and economic terms. From covering medical needs and family emergencies, to financing movie projects and selling innovative tech gadgets all the way to peer-to-peer lending, crowdfunding has established itself as a tool whose future role in our global society can only be guessed.

But at least for the near future, crowd equity funding – the crowd funding variety that could channel investments into entrepreneurial companies during various critical stages of growth – does not appear quite as powerful. A Dubai-based crowd equity funding platform, Eureeca, approached the regional market over two years ago and set up a small branch office in BDD, but the evidence of its acceptance is slight.

According to a story in Bloomberg Business Week from last June, the platform accounted for a fundraising tally of $2.5 million since start of operations; the Eureeca website, which does not show incomplete deals where funding goals were not reached, last month showed 13 completed projects with achieved funding amounts ranging between $86,500 and $243,000, for a total of around $1.8 million over two years of operations. All these projects were located in either the United Arab Emirates or Jordan and a quick query of Operations Executive Wafic Sultani at the Beirut office yields no news of local equity raising projects being added to Eureeca’s pipeline.

Crowd equity funding also has inherent conceptual shortcomings, maintains Habib Haddad, founder and CEO of entrepreneurship platform Wamda. “I am not a believer in crowd equity funding in the region or globally. Crowdsourcing is a better avenue in the way that your product has customers but when it comes to crowd equity funding, what you want from your investor is support, connections, brains, value etc., and it is very hard to crowd source that,” explains Haddad who is also a member of the World Economic Forum’s Global Agenda Council on entrepreneurship.

Nothing, however, could imply that crowd equity funding is a dead-end idea. In the US, the startup arena that still drives developments globally, the concept appears to be maturing, albeit ever so slowly. The Securities and Exchange Commission (SEC) released partial crowdfunding rules for investors in March of this year as directed by the 2012 Jumpstart Our Business Startups (JOBS) Act legislation in support of small business creation in the United States.

Given the SEC’s outsized weight in the international regulatory landscape for securities trading and equity markets, the agency’s regulatory action is expected to fuel a boom of activity on crowd equity funding platforms around the world despite the fact that an important part of the SEC rules on the JOBS Act – namely the part allowing funding portals to act as gateways for crowd equity funding – has not been published by the time of this writing and could not go into effect before 2016 even if it were announced by end of October 2015.

While politics and control issues between the federal and state authorities are in play in American debates over crowd equity funding, it would be an error to see the relative slowness in the formulation of regulations as empty obstructionism. It is more likely to help in mitigating the risks of rapid expansion in the equity corner of investment democratization. As Haddad says, “the US hesitated to regulate crowd equity funding for a reason, namely to protect the investors. Investors have to invest into 20 startups to make money from one, so it is risky.”

A new exchange formula

The other big avenue for price discovery and mobilization of equity for startups and entrepreneurial companies could be the electronic stock market for small and medium enterprises (SMEs) that has been announced repeatedly by Riad Salameh, governor of Banque du Liban (BDL), Lebanon’s central bank, during entrepreneurship conferences and meetings.

The electronic exchange’s primary aim would be to provide liquidity to SMEs, Salameh has been quoted as saying time and again in the past twelve months. As a secondary market that serves the needs of entrepreneurial companies and their investors, the electronic exchange could be a valid proposition to help fill the funding gap for the startup ecosystem, agrees Samer Karam, CEO of Startup Megaphone and a very active stakeholder in it. “I think the way in which [BDL] implemented Circular 331 [qualifies] the implementation of this program as a unique structure worldwide. If [BDL] can be as creative and innovative with their secondary market, it might have a chance to bridge the growth stage financing gap that will become apparent in two to three years,” he says.

However, powering up the electronic exchange does in no way look as if it will be easy. One organizational requirement in the original plan for such an exchange is the privatization of the Beirut Stock Exchange as purported owner of the new market. That alone looks so improbable a project for the near or even mid term that it is not worth asking about it. There are also presently no indications available about the listing requirements and operating rules of the electronic exchange as the Capital Markets Authority has not divulged its thinking on those matters. Further obscurity relates to the market’s preparedness and readiness of crucial stakeholders. Will venture capital and private equity players be ready to use the new market place? Will entrepreneurial companies come with prepared minds?

When Executive contacted VC firms and inquired about their views on the electronic exchange project during the past three months, many responses were generally favorable but unspecific. It became clear that funds managers and Private Equity (PE) experts had had neither reason nor opportunity to contemplate exit strategies that might involve a public offering on Lebanese turf. Investment banks likewise would not have entertained the idea of taking companies to the proposed electronic exchange. He had not done so, “not even as a mental exercise, because the companies are not ready,” says Khaled Zeidan, the executive general manager of Medsecurities, the investment banking unit of Bank Med.

Zeidan points to an important further missing link in the creation of a secondary market for entrepreneurial companies. “A small cap exchange will not work unless there is liquidity and liquidity will not happen unless there are rules for market making, transparent laws and proper governance in that respect. These have to go hand in hand and I don’t know if the conditions are right for that today,” he explains.

For Startup Megaphone’s Karam, there is also not much in terms of precedents in the attractiveness that a small cap exchange could provide to startups and young tech companies. A market such as the London Stock Exchange’s Alternative Investment Market (AIM) was by his experience not on the radar of the startup community. “I know a lot of startups in London but I don’t know a single one that is involved in AIM. I also don’t know a single [startup] ecosystem that uses small cap exchanges – what countries like Singapore are doing is seeking to attract large growth-stage VCs to their countries. I have been sitting with the head of the Singaporean company in charge of the ecosystem there and I can tell you that nobody is looking at secondary markets for their ecosystems. I don’t hear about it,” he shares.

The absence of clear plans for the Lebanese electronic exchange makes it practically impossible to assess the viability of the concept and a lot of water has run down the Hudson since the days when the NASDAQ was launched as a small cap exchange as noted by Zeidan. However, while stock markets traditionally have sought to appeal to companies after they have advanced beyond the entrepreneurial stages of business, there have a number of exchanges targeting younger and tech driven companies since the first boom of the digital economy in the late 1990s.

New Policies and a pot of luck

Some of these new markets failed completely and others never achieved the momentum of a NASDAQ but the recent past has seen new investments in exchanges that aim their services at young tech companies. One such step was undertaken only last month by NASDAQ itself, which invested into the proposition of pumping equity into private companies by buying SecondMarket, a platform that was developed with a focus on private tender offers.

The Financial Times called the move, whose value was not disclosed, an “aggressive attempt to build up a little-developed area of market infrastructure” (Oct 22). The context is that tech companies in the US have become slower in jumping into initial public offerings; the new infrastructure will allow NASDAQ to facilitate private tender offers in which employees or VC shareholders in fast growing companies can sell their shares independently from an eventual initial public offering.

Crowdfunder, a stakeholder in the American digital economy, commented gleefully that the investment points to a rising competition among US exchanges for attracting SMEs, saying that the revised NASDAQ Private Market is fishing in the same waters as the, also fairly recent, OTCQB venture marketplace of exchange operator OTC Markets.

The concept of venture marketplaces, which is a term to describe exchanges targeting entrepreneurial and young companies, has also recently gained political currency in the US. Last summer, a legislative initiative was circulated in the House of Representatives’ Financial Services Committee calling “to allow for the creation of venture exchanges to promote liquidity of venture securities, and for other purposes.” Venture securities, under the proposal, are securities issued by early-stage, growth companies – meaning companies with less than $2 billion in consolidated assets which also meet the requirement of having not made any initial public offering.

“The new proposed venture exchange laws are aimed at increasing access to liquidity for early stage investors in private startups and small businesses,” said Chance Barnett, CEO of Crowdfunder, in an opinion contribution to Forbes.

Yet a different example for the new potency of venture exchanges comes from Canada where the Canadian Securities Exchange (CSE) touts its horn as “the exchange for entrepreneurs” and claims to be the fastest growing exchange in the country. In 2014, their portfolio rose 34 percent to 244 companies and reached 291 traded stocks by end July 2015. The peculiar thing about the CSE is that its growth momentum of offering a combination of low cost and high standard services to companies listing their securities on the exchange is additionally boosted by unconventional business focuses from a good number of companies which have recently floated their shares on the CSE.

Of four new listings last month, two were miners, one a tech, and one a life sciences company. Tech and mining are the top sectors but it is in life sciences where the buzz can be sought. The new company in this sector is called Golden Leaf Holding, and their business is cannabis, looking at both the medical and recreational potentials. Over 10 percent of the CSE-listed equities are in the life sciences bracket and the majority of these firms have business plans that are related to making legal hash money.

Moreover, the CSE’s top companies in terms of trade volumes and traded values this year have affinity with the flowering herb. A notable political boost for the CSE thus came from the Liberal Party’s election win last month, as the party aims (for the third time) to legalize pot and officially trumpets that it “will design a new system of strict marijuana sales and distribution, with appropriate federal and provincial excise taxes applied.”

The unknown spice

The potential for secondary markets that tie in with entrepreneurs and tech startup ecosystems certainly looks to be related to local specificities in the underlying economies and project for a market activation in Lebanon certainly would have to overcome many obstacles, from the comatose state of stock trading and the underdeveloped capital markets structure to the lack of an experienced and dynamic market operator. But the risk of doing something that no one has done successfully before has a double appeal of an entrepreneurial adventure – that spirit that the Lebanese startup miracle is fundamentally based on – and of the chance of first-mover advantage. From the global experience with junior exchanges, having a private venture market that is not a subsidiary of a main market might in this context actually be a plus for the project.

Numerous governance bridges will have to be crossed for an electronic market for startups, entrepreneurial companies and innovative SMEs to be viable. Firstly of course, operating standards and policies of highest caliber will have to govern the exchange itself. But another debate that is hardly even in its beginning stage is needed: how much governance is needed in making a startup ecosystem future proof? This is a matter where the majority of the ecosystem’s current stakeholders have little to no experience or perspective.

Governance is no fun, asserts Medsecurities’ Zeidan, but dismissing it for aspiring entrepreneurs would be counterproductive. “You need to add governance but not to the point that people flee your business,” he says. “Governance should obviously be in place from the beginning but at the same time you cannot kill the entrepreneurial spirit of a small entity and have them waste all of their time on reporting and not developing anything. There is an ongoing struggle but governance should clearly be part of the DNA of a company as early as possible.” This discussion is just beginning.